Law Street in The Economic Times (Feb 24, 2012)

Dear Readers,

Just when we had thought that the Supreme Court's verdict in Vodafone's case had brought about clarity on India's right to tax in instances of indirect transfer, a review petion filed by the tax authorities has once again created an element of uncertainity.
The Economic Times has reported a few days ago: The Income-Tax Department has filed a review petition in the Supreme Court asking it to reconsider its verdict dismissing the government's $2.2-billion tax claim on telecom company Vodafone, but the UK-based group appeared unfazed.The department has sought the review on the grounds the judgement suffered from errors, failed to consider its submissions, and that certain provisions in the income-tax law had not been correctly interpreted.
Meanwhile in the February column of Law Street, Zenobia Aunty looks ahead at the provisions contained in the draft Direct Tax Code and wonders whether the government will cherry pick some of the provisions, especially those relating tax in India on indirect transfer of shares and introduce them in the Finance Bill in the coming month. The column is available online here, and as always it is also cut and pasted below.
Best regards,
Lubna


Taxing indirect transfers

Tax provisions on indirect transfers must be clear
Exemptions must be granted for intra group transfers
Valuation comparisons should be date specific

Lately Zenobia Aunty has been very busy. Seminars, lunches and dinners, to discuss the landmark Vodafone judgement are still going strong. Understandably tax practitioners are jubilant with the Supreme Court’s verdict. As we wait for the Finance Bill, 2012, to be unfolded the question uppermost in everyone’s mind is whether this joy of the tax practitioners will be short-lived.

It is well known that in 2009, China introduced a legislation to tax an indirect transfer of a capital asset situated in China. It is believed that the Chinese authorities borrowed a leaf from the Indian tax authorities’ action in Vodafone’s case. Circular Number 698 requires non-resident transferors to report their share transfer transactions, together with the relevant supporting documentation, including share transfer agreements, after they indirectly transfer their equity interests in Chinese resident companies, via disposal of intermediate holding company. This is required to be done if the resultant tax on the transaction through the use of the intermediate holding company is less than 12.5 per cent.
Chinese tax authorities then examine the transaction. If it is found that the intermediate holding company has no business substance and was set up only for tax avoidance, the transaction is regarded as transfer of shares of the Chinese resident company (and not that of the intermediate company) and is subject to tax in China. Since issue of this circular, in a number of cases, the Chinese tax authorities have ‘looked-through’ the intermediary companies and taxed the transaction in China.

From a technical legal perspective, the provisions of Circular 698 or even Chinese General Anti Avoidance Provisions (GAAR) apply only to corporate tax payers and are governed by the framework of corporate tax laws. However, in recent months, a case has been reported on the collection of individual income tax of close to USD 2.1 mn on the capital gain arising from an indirect transfer of an equity interest in a Chinese company through an offshore transfer of its Hong Kong parent by a Hong Kong resident individual. The fear among the business community is that this case could be used as a guiding principle when dealing with non-resident individuals and not just corporate tax payers.

At one point of time, when grey clouds shrouded the tax frontier in India, global tax payers had felt that at least the Chinese tax laws provided some clarity on tax incidence as regards indirect transfer of capital assets. But with the wide interpretation now given to this circular by the Chinese tax authorities, which has roped in even individual tax payers, there is understandably a sense of apprehension.

Coming back to perhaps what the future holds in India. Section 5 (1) (d) of the Direct Tax Code (DTC) seeks to bring within the tax ambit direct or indirect transfer of a capital asset situated in India. Section 5(4) (g) adds that: The capital gains would not be deemed to arise in India from such transactions unless at any time in twelve months preceding the transfer, the fair market value of the assets in India, owned, directly or indirectly, by the company, represent at least fifty per cent of the fair market value of all assets owned by the company.
The intent of introducing the above provision seems to be to cover cases where ‘controlling interest’ in an Indian company is sought to be transferred outside India, by transferring shares of the foreign company which holds shares in the Indian company. Considering the unintended consequences that could arise owing to ambiguity in the language, the coverage of indirect transfer may be restricted to cases where: (i)The foreign company whose shares are transferred owns, directly or indirectly, more than 50% of the share capital of an Indian company and (ii) The shareholder transferring the shares of the foreign company, should own more than 50% of the share capital of the foreign company.

Further the window period of twelve months referred to in valuation could lead to practical difficulties. For the purpose of comparison of the values, the comparison should be should be restricted to the balance sheet date immediately preceding the date of transfer. A merger of two foreign companies should also not result in tax implications in the hands of the shareholder on account of indirect transfer of capital asset. Additionally, an exemption should be granted for intra-group transfers. Indian tax laws do provide for tax incidence in the hands of the representative assessee. From a practical perspective, a representative assessee must be one who has possessed the non-residents money in the course of the transaction.

Be it China or India, tax authorities are keen to gain a bigger slice of the tax pie, but ambiguity hurts. Investor confidence is now riding high as far as India is concerned, appropriate amendments in the DTC will be of an added help.


Source of the photograph